What The Beats Deal Means For Apple

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Ending weeks of rumors, Apple (NASDAQ:AAPL) announced Wednesday that it would be buying popular audio products manufacturer Beats Electronics and its fledgling music service business Beats Music for about $3 billion, making it the largest acquisition in the company’s history. Apple will pay roughly $2.6 billion in cash with an additional $400 million in equity that would vest over time. Apple projects that the acquisition, which is expected to close in fiscal Q4 2014, will be accretive to its fiscal 2015 earnings. [1] The deal marks a departure of sorts for Apple, which has traditionally focused on acquiring companies with niche technologies and talent that it can incorporate into its products and services, instead of buying well known consumer brands. Following the acquisition, the Beats brand will continue to exist alongside Apple’s brand. While it is likely that Apple is paying the bulk of the acquisition price for the electronics business, much of the future value could lie in the music streaming service and the talents of the Beats team. Here’s a brief rundown on what the deal could mean for Apple.

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Audio Products Business Likely Very Profitable, But Risks Exist

Beats Electronics primarily sells headphones, speakers and audio software. The company’s wildly popular headphones retail from $99 to about $450 in the United States, while its speakers retail for upwards of $199. The premium end of the headphone market (prices $100+) in which beats operates remains the fastest growing segment in the headphones space.  According to research firm NPD, the premium headphone market in the United States grew by around 21% in 2013, crossing the $1 billion mark. [2] As of June 2013, Beats held about 59% of this market. [3] While Beats electronics hasn’t disclosed historical financials since it was private, its margins are likely very healthy and should comfortably meet Apple’s gross margin requirements. According to the New York Times, a pair of its high-end headphones may cost as little as $14 to manufacture. Additionally, Apple could further drive up Beats’ revenues by expanding the business into new countries via Apple stores as well as select Apple Authorized Resellers.

However, we believe that there are some risks in the audio products business. With the Beats acquisition, Apple isn’t exactly buying into cutting edge audio technology or intellectual property that it wouldn’t be able to develop in house. Beats audio products routinely receive mixed reviews from critics who often cite them as being overpriced for the listening experience that they offer. Beats products have gained market share due to their slick design and celebrity-driven marketing, and these attributes could run the risk of being a fad.

Apple Could See Value In Streaming Service

While the headphones business remains the most recognizable part of Beats, the Music streaming service is likely to have been a key reason behind the acquisition. Apple is no longer the formidable digital music powerhouse that it once was, with the advent of online streaming music services such as Spotify. Unlike Apple’s traditional iTunes model of making customers pay for specific content while locking them onto its platform, online music streaming services offer much more flexibility to consumers, allowing them to listen to a vast library of songs on-demand and across devices for a small monthly fee, or for free with ads. These services have seen a significant uptake over the last few years, and this has been impacting Apple’s iTunes business. According to Morgan Stanley Research, revenues for Apple’s iTunes have been declining over the last three quarters. [4]

While Apple does offer an Internet radio service of its own, iTunes Radio, which competes with the likes of Pandora, it lacks an on-demand streaming service. On-demand streaming is becoming increasingly popular with consumers since it allows them to pick and choose the individual songs they want to listen to. This is likely where Beats Music comes into the picture. While Apple could have developed its own on-demand streaming service, the Beats acquisition gives the company an instant entry into the space. Moreover, Beats Music has received largely positive reviews, winning praise particularly for its curation of content. Subscriptions costs about $99.99 per year or about $10 per month, and the service has signed up about 200,000 paying customers since its launch in January. Although this remains a fraction of Spotify’s 10 million+ paying customers, the user base could be poised to rise with Apple’s acquisition.

Co-Founders’ Industry Connections Could Be Beneficial

Beats co-founders Jimmy Iovine and Dr. Dre are influential figures in the music industry. The duo, who are set to join Apple in undisclosed roles, will bring in a strong understanding of the market and popular culture, in addition to their deep connections within the music industry. This could prove invaluable for Apple, particularly in its negotiations with music companies, a role which was often handled by the late Steve Jobs.

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Notes:
  1. Apple Press Release []
  2. Premium US Headphone Market Surpasses $1 Billion in 2013, According to NPD, NPD Group, March 2014 []
  3. Beats By Dre Looks to Drop HTC, WSJ, August 2013 []
  4. Apple: App Store to Lift Services Revenue, Profit, Says Morgan Stanley, MarketWatch, May 2014 []